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The Underperform Case for Gander Mountain

To truly the measure the performance of a decision, you must evaluate the input as well as the outcome.

I want our readers to get the most out of Motley Fool CAPS. That's why I want to attach a detailed write-up (a "pitch," in CAPS parlance) to every CAPS decision I make. If, according to Michael Mauboussin, the top investors focus on the process (launches .pdf file) along with the outcome, then why shouldn't I do that as well?

So before I make my "underperform" call on outdoor retailer Gander Mountain (NASDAQ:GMTN), I think it's only fair to lay out my case so that I, or any of you, can go back and evaluate the input along with the output. Not only will that allow me to evaluate the decision, but it'll give me a record to look back on and learn from.

It starts with the storesI learned about Gander Mountain while researching Cabela's (NYSE:CAB). The first thing that jumped out at me was the difference in the competitors. Below is a comparison.

Number of stores

Average Size (ksqft)

Productivity ($/sqft)

Gander Mountain

105

52.2

$175

Cabela's

17

159.1

$350

Ksqft = thousands of square feet. Data for last fiscal year from Capital IQ.

Immediately, it's easy to see that Cabela's is getting more out of its larger-store format; twice the productivity from stores that are three times as large is pretty incredible for Cabela's. That doesn't bode well for Gander Mountain, especially given the extra competition from Dick's Sporting Goods (NYSE:DKS), Big 5 Sporting Goods (NASDAQ:BGFV), Wal-Mart (NYSE:WMT), and Sears Holdings (NASDAQ:SHLD). Let's see how this relative underperformance trickles down to other financial metrics.

Creeping cash conversionAnother thing that jumped out at me is the time it takes Gander Mountain to convert inventory into cash, also known as the cash conversion cycle. Once again, the company is lagging behind a leader like Cabela's (if you're wondering, data for privately held Bass Pro Shops is not available).

Cash conversion cycle in days

FY2004

FY2005

FY2006

Gander Mountain

149.0

153.4

156.1

Cabela's

85.3

86.8

83.8

Data from Capital IQ.

So not only are its stores more productive, but Cabela's also gets its cash almost 50% sooner. The big culprit is inventory, which hangs around about 30% longer in Gander Mountain stores. That could mean a few things: Cabela's has better selection, Cabela's has better pricing, or both. Either way, Gander Mountain's stores aren't producing as many sales -- or as much cash.

Return on invested capital stinksGander Mountain really underperforms where it counts the most: return on invested capital (ROIC). I believe that, over the long term, the market rewards companies that consistently generate above-average returns. That's definitely not happening at Gander Mountain and, in my opinion, isn't likely to happen for a while.

Adjusted for its operating leases, I calculate that Gander Mountain produced an ROIC of 5.9% last year, compared to 10.2% for Cabela's. So not only is Gander Mountain destroying value with the capital it's used, it severely lags a leader in the space.

Gander Mountain management has been talking about getting big by opening new stores in order to gain efficiencies of scale. Let's determine the operating margin required to come to parity with Cabela's.

Currently, Gander Mountain generates an operating margin of 1.5%. In order to generate an ROIC of 10.2%, it would have needed an operating margin of 5.5% last year. An almost fourfold increase is just too tall an order for stores that simply aren't as productive as those of one of its toughest competitors.

I think the market is mistakenSo when I look at where Gander Mountain is trading today -- at an EV/EBIT ratio of 36.6 -- I have to think the market is making a mistake. Clearly, investors believe the company's performance will fill in to justify trading at a premium to Cabela's multiple of 11.6. I'll fully admit that multiples are shortcuts, but I think the market is making a mistake in giving Gander Mountain such a high valuation. Add in the fact that Gander Mountain carries considerably more financial risk, with an interest coverage ratio of 1.9 compared to Cabela's ratio of 10.1, and I would be even more scared to hold Gander Mountain shares at these levels.

My CAPS callThat's why I am going to rate Gander Mountain an "underperform" in CAPS. The summary of my thesis is that Gander Mountain is in an inferior position to Cabela's, and that position will weaken further as both companies grow the number of stores. When the financial performance the market currently expects doesn't fill in, the market is going to be sorely disappointed. No one wants to be holding an overpriced stock that has disappointed the market.

Since price determines returns, I'll try to be as opportunistic as I can with my underperform call. And a year down the road, after I've made it, I will look back on my input and my outcome to see how I did.

Retail editor and Inside Value team member David Meier is ranked No. 9,908 out of 30,759 in CAPS. He owns shares of Cabela's but does not own shares in any of the other companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.